How to Assess the Credit Risk of Your Customers

Darren Dahl is a contributing editor at Inc. magazine, which he has written for since 2004. He also works as a collaborative writer and editor and has partnered with several high-profile authors. Dahl lives in Asheville, North Carolina.

Contributing Editor, Inc.

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When Jeff Huckaby started RackAID, an IT management business in Jacksonville, Florida, he considered himself lucky to have landed a couple of larger clients right off the bat. Eventually, those larger clients accounted for as much as 40 percent of his company's revenue. While Huckaby knew his business was "top heavy," meaning he was tied to those big customers, he wasn't worried. Turns out, he should have been. One day, an expected payment from one of his key clients didn't arrive. When he called up his contact to find out what had happened, no one picked up the phone. A week later, he got a call back telling him that his client was canceling the project because they didn't have the money to pay for it, despite the fact that his company had already spent money lining up other vendors such as an Internet service provider. The result was that Huckaby not only lost the potential revenue from the contract, he was also out of those out-of-pocket expenses. "It was a nightmare scenario," Huckaby says.

Stories like Huckaby's are all too common, especially these days. Companies and consumers alike who are hit by hard economic times will either try to stretch out their payments or, worse, fail to pay at all – something that can be disastrous for a small, growing business. That's why it's more important than ever to assess the credit risks associated with selling to a customer before you close the deal, no matter how loud your sales team hollers, says Alex Cote, who heads up marketing at Cortera, a business that provides corporate credit reports based in Boca Raton, Florida. "Obviously everyone needs money coming into the company," he says. "But you can't let sales overrule financial prudence."

Fortunately, there are several steps and actions you can take with your business to try and reduce the risk of selling to that next big customer.

Step 1:Lay Out the Facts

Sometimes the best way to assess the viability of a customer and to prescreen who might be a fit is to simply lay out the facts, says Andra Watkins of POSITUS consulting in Charleston, South Carolina. "The best advice I give to any small business is to openly discuss fees and product costs up front with clients and customers," she says. "Be honest about what things cost and why. While some negotiation regarding cost is the norm these days, lots of pushback on cost almost always indicates a person who will not pay the bill in the end. The more concerned people seem to be about cost, the longer they take to pay."

Just because your potential new customer doesn't balk at your up-front terms doesn't mean they don't have a few skeletons lurking in their financial closet. One clear-cut method for assessing your customer's ability to pay, therefore, is to run a credit report on them. For consumers, you can turn to any of the major credit reporting agencies such as TransUnion, Experian or Equifax. For your business customers, there are several fee-based options available to you.

Cote says that the first thing you should do with any client is to ask them to fill out the basics of a credit report. There are standard forms available on the Internet that typically range from one to two pages and ask for information such as the name and principles of the business, its business address and contact information. But, Cote advises that you have your lawyer look over any form before you ask anyone to fill it out, just in case. If a client or customer balks at handing over such information, the reason is almost always because they have bad credit, he says.

After his client burned him, Huckaby, for example, began running reports on all of all his key clients using Dun & Bradstreet, the preeminent corporate credit rating agency. For a fee that ranges from about $40 for a one-time lookup to $179 for unlimited monthly lookups, business owners can check to see the credit rating and recent payment history of clients.

Huckaby says that after he began using D&B's service, he could track when a client's credit began to decline and, if the client didn't have a good answer as to why, he could pull back on his expenditures and pursue collecting late payments more aggressively. "This has saved us thousands of dollars of potential lost revenue and costs," he says.

There are other options as well, such as the service offered by Cortera, which, for $5, provides an accounts receivable aging report on a company along with other relevant information pulled from public records and other information found on the Internet. Another service to consider is Debtwatcher, an online database that, for monthly fees beginning at $60, pulls data from collection agencies to show if a company has had claims levied against it.Dig Deeper: Credit Evaluation and Approval

Step 3: Check References

Another option available to you is to ask your customer for references, says Dayna Steele, founder of Steele Media Services in Seabrook, Texas. "See if they have clients listed on their website and call the accounting department for a reference," she suggests. Also ask them who they have been given trade credit from in the past and for how long they have maintained those relationships. You can also ask for bank references. While banks typically charge for this service, you can find out how long a business has been working with them and whether they have established a line of credit.

In addition to purchasing information about your clients, you can also spent some time collecting information on your own to help ascertain how risky they might be.

"You need to always rely on gut instinct as well as traditional methods of checking credit," says Steele. "Do they answer e-mails in a timely manner? Do they have a professional e-mail address and website? It's harder these days to cover up problems, if there is one, it can probably be found online."

Consider the approach used by Scott Gerber, founder of Sizzle It!, a New York City-based PR company, to research his customers. Before he takes on any client, he visits their website and assesses the size of the company based on the client roster in addition to assessing how well it uses the English language. "Because large companies rarely have spelling or grammar errors and small businesses do," he says. Gerber also searches blogs and forums to see if his potential client has received any negative feedback from clients or other vendors on sites such as Facebook, Yelp or Twitter. Another step he takes is to see who the company sells to as a way to determine how much potential revenue the company is earning. "This helps us to determine whether or not we believe the prospect is a cash cow, a healthy catch, a shoe string or a dead beat," he says.

Cote says another simple trick can be to use Google's "streetview" map feature to assess whether the location the business provided makes sense or not. For instance, he cites a story about a supposed trucking company that provided an address that was in a residential neighborhood. "That's the kind of things that should set off alarm bells," Cote says.

It's also important to remember that, all things being equal, you might still like to close a sale or establish a relationship with your new customer. That means that you can consider alternative ways of working with your new client by, say, asking for up-front payment or a substantial deposit.

For Gerber at SizzleIt!, anyone who has questionable credit, needs to come up with cash if they want to continue working with him. "Always get a large chunk of money upfront before you get started," he says. "This will instantly tell you if someone is for real or not." He also recommends waiting to begin on a project until a check clears and to enforce a strict penalty fee for late payments. "Above all else, make sure you get everything in writing on a contract that has been approved by an attorney," he says.